Interprovincial Trade Barrier for Intermediate Goods and Firm Innovation: Evidence from China

Abstract

I examine the impact of interprovincial trade barrier for intermediate goods on firm innovation in the manufacturing sector in China over the 2003-2013 period. In particular, I construct a theoretical framework for innovation decisions of multiproduct manufacturing firms with price rigidity and contend that a decrease in interprovincial trade barrier for intermediate goods would increase firm-level R&D intensities in the short term due to price rigidity, but such effect would fade in the long term. I also make use of a structural gravity model to quantify interprovincial trade barrier for intermediate goods for each Chinese province in each year between 1998 and 2017. Then, taking advantage of a series of reduced-form regressions, I show that a decrease in interprovincial trade barrier for intermediate goods could indeed encourage firm innovation. Numerically, firm-level R&D expenditures would increase by approximately 28% in response to a one standard deviation decrease in interprovincial trade barrier for intermediate goods. I correct for endogeneity using a dummy indicating whether a provincial number one leader is locally or non-locally promoted. My findings are robust to this correction. Finally, I explore the heterogeneity and find that the magnitude of the effect exerted by a decrease in interprovincial trade barrier for intermediate goods increases in ex ante firm-level R&D effort and decreases in the level of market competition in the province.